What is a home equity loan?

Home equity loan is a loan where the borrower uses the equity in his home as collateral for the mortgage loan. Equity is the difference between the home’s current market price and the mortgage amount to be paid by the owner. For example, if you buy a home which is worth $200,000 and you have to make mortgage payment up to $60000 then the equity amount is $200000 – $60000 = $140000. Equity can come from two sources. One which is the mortgage payments, which if paid regularly reduces the amount that is owed against the property. The second is the appreciation in the value of real estate over time. After several years of making mortgage payments, the equity accrued can be substantial. For example, if you have purchased a house worth $200,000 and have regularly made mortgage payments for the past five years such that you now owe $130,000 in mortgage repayments. After five years if the value of your property has increased to $300,000, your home’s equity can be calculated as 30000 – 130000 = 170000. Your equity increases with the increase in your property’s worth. Collateral is the property that is pledged as a guarantee to repay the debt. In a home equity loan the home is the collateral, pledged by the owner to the bank against the default risk of not being able to meet the interest payments. Home equity loans are also referred to as second mortgages and it enables you to turn your equity into cash that you can use to spend on other expenses such as on home improvements, debt consolidation, college education or other expenses. It is a one-time lump sum payment; you receive from the bank and which you repay over a period of time. The rate of interest is fixed and you pay same amount every month for the period of the loan. Once the loan is availed, you cannot borrow further from the loan. Banks and financial institutions are ready to give home equity loans because real estate is considered to be a very stable investment. The interest rate for a home equity loan is much better compared to auto loans or credit card debts but it is still higher that interest payment on the first mortgage. If required, you can convert a home equity loan into a first mortgage through a process known as refinancing.

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